Liebig’s Law of the Minimum: "Only by increasing the amount of the scarcest nutrient can the growth of a plant or crop be enhanced, despite the plentiful presence of other nutrients." - Compass Minerals International, Inc., 2018 Annual Report
What had happened?
At the time, seeds of trouble were already planted:
- In 2014, under then CEO Fran J. Malecha, Compass started an aggressive five-year investment plan to transition its crown-jewel Goderich rock salt mine in Ontario, Canada, to continuous mining to improve efficiency, and to expand the Ogden, Utah, sulfate of potash (or SOP) facility. While the Ogden expansion progressed as expected, the Goderich upgrade was poorly managed, from engineering to labor relations.
- The company's acquisition of Produquímica in Brazil in 2015 (35%) and 2016 (100%) helped pile up an excessive amount of debt such that its Debt/EBITDA metric staying as high as 4.3X to this day.
All of these capital-intensive projects went on while the Salt Belt, where the company pulled in 56-71% of its revenue, had some of the least snowy winters three years in a row between 2015 and 2017 (Fig. 1).
Fig. 1. Compass salt segment sales and snow activity, defined as the sum of days with one or more inches of snow in 11 selected U.S. and Canadian cities in Compass’ service area, as reported by the NOAA National Weather Service or Environment Canada. Source.
Consequently, Compass ended up reporting negative free cash flow in two consecutive years (2015 and 2016); its bottom line crashed in 2017 (Fig. 2). Fig. 2. Free cash flow versus dividend distribution (upper) and earnings and dividends per diluted share (lower) of Compass. The 2019 dividends are expected to be in line with 2018 and EPS is estimated based on the company's guidance. Source: Laurentian Research.
Because they have been paid growing dividends (Fig. 2), shareholders were patient with the management from 2012 to 2016, when the stock fluctuated around $80 per share. However, as more and more operational problems surfaced, shareholders became increasingly unhappy and many voted with their feet. The stock lost 5.5% in 2017 and a whopping 44.0% in the following year (Fig. 3). Malecha stepped down in November 2018.
Fig. 3. Stock chart of Compass Minerals. Source.
At this juncture, while wound-licking and lesson-learning have probably been ongoing within the company, we investors need to ask the following questions:
- Has the competitive advantage once boasted by the company survived the debacle of the last few years?
- What is the near-term outlook of the business? Is it going to get worse or are positive changes afoot?
Competitive advantage reassessed: salt
Compass now reports results in three business segments, i.e., salt, plant nutrition in North America and plant nutrition in Brazil. As of 1Q2019, salt accounts for 58.6% of the consolidated revenue and 58.4% of the consolidated EBITDA, while plant nutrition accounts for 41.4% of the consolidated sales and 41.6% of the consolidated EBITDA (see here).
Controlled salt markets. The annual demand in Compass's addressable markets of highway deicing, consumer, and chemical manufacturing in North America and the U.K. fluctuates around 48 Mt/y, depending on winter weather conditions. Salt demand grows at approximately 1% per year (see here).
Compass has a total salt production capacity of 15.6 Mt/y; theoretically, it can take 32.6% of the total demand, but in reality, it only captures approximately 22.6% of the market share as of 2018. Given the smooth running at Goderich and Cote Blanche, the management looks to recover in 2019 some market share lost to competitors in 2018.
- In North America, Compass, along with Cargill and K+S (OTCQX:KPLUY), forms an oligopoly which controls over 80% of the market, with a few smaller producers making up the balance (see here).
- As a bulk commodity, salt has high transportation costs, which helps erect barriers to entry that protect local salt miners. The company operates the Goderich, Ontario Mine (the largest in North America), the Cote Blanche, Louisiana Mine, the Ogden, Utah Solar Evaporation Plant, and three mechanically evaporated salt plants in Canada. Goderich and Cote Blanche, through waterways and depot network, supply the Great Lakes region and Ohio River tributaries, lending a significant cost advantage to the company. The East Coast part of the Salt Belt and the West Coast markets are occupied by salt imports, where the company has a minimal market presence (Fig. 4).
Fig. 4. The primary served highway deicing markets, shown with sites of underground salt mines and evaporation production plants (lower), from source; deicing salt delivery routes to depots from two underground salt mines and one solar evaporation facility (lower), from source.
- In the U.K., the company captures 75% of the highway deicing market under multi-year contracts of supply from the Winsford, Cheshire Mine - the largest in the country, with two other competitors, one in Northern England and one in Northern Ireland, making up the balance.
- The company is the third largest producer of consumer and industrial salt products in North America and is among the largest private-label producers of water conditioning salt in North America and of table salt in Canada (the Sifto brand).
Price of salt. As I explained elsewhere, salt products have some unique attributes:
- They are relatively low cost to end-users.
- They are also recession-resistant and non-cyclical, similar to consumer staple goods.
- There are essentially no substitutes. Over the years, numerous alternative deicing materials have been investigated and tried, but none of them come close to rock salt in terms of wide availability and low cost. For example, calcium magnesium acetate (or CMA) is proven to be effective but it costs 20 times more than rock salt (see here). Cargill has been promoting its CG-90 series of products, which costs over 2.5 times of the ordinary rock salt; Calcium chloride is hygroscopic and exothermic but costs more than 3 times than rock salt; Verglimit, a patented bituminous concrete pavement that contains calcium chloride pellets encapsulated in linseed oil and caustic soda, costs about 33 times the cost of asphalt and is suspected of causing deadly accidents (see here).
Thanks to these factors, Compass was able to raise salt prices by 3.9% per year on average in the past 15 years. Even in 2015-2017, when especially mild winter weather conditions persisted, the salt price remained at relatively high levels (Fig. 1; Fig. 5).
- According to the latest USGS data, during the 30-year period ending in 2016, salt prices in the U.S. have increased at a historical average of approximately 3%-4% per year (see here).
Fig. 5. The trend of average realized price. Source.
In assessing the competitive position of Compass as a salt supplier, we have to look through changes in weather conditions from one winter to another (Fig. 1) and see the true long-term trend. The above discussion suggests:
- The competitive landscape remains oligopolistic, without new entrants, as secured by its strategic holding of long-life, enormously-sized salt mines (84 years at Goderich under renewable mining license, and 102 years at the licensed Cote Blanche) on far-reaching waterways (Fig. 4).
- There are no viable substitutes to rock salt as a deicer and to table salt as an essential food additive.
- Labor issues at the Goderich Mine is a matter to be concerned with, but its impact on input costs is likely to be largely neutralized or more than offset by efficiency initiatives, particularly as the continuous mining is now up and running more smoothly.
- The company continues to maintain an advantageous bargaining power over buyers of highway deicing salt, as can be seen in the realized salt price trend (Fig. 5).
Therefore, I believe the sustainable competitive advantage commanded by the company is still intact, unharmed by the mismanagement over the last few years and certainly not by the uncharacteristically long stretch of mild winters between 2015 and 2017.
Competitive position in plant nutrition
Compass produces salt at the Ogden, Utah, solar evaporation plant on the Great Salt Lake, the largest SOP production site in North America and one of four large-scale solar brine evaporation SOP operations in the world, under a renewable license from the state. The Ogden facility has been expanded to a capacity of 550,000 t/y of SOP in 2017, including amounts produced with both solar-pond-based and purchased KCl feedstock. The company also has the Wynyard, Saskatchewan, Canada facility on Big Quill Lake, which is capable of producing 40,000 t/y of SOP (see here) (Fig. 4). The company has been investing in these facilities in order to lower production cost and stay competitive in pricing (see here).
The company launched four plant nutrition products in 2018 and six are planned for 2019. In early 2018, it opened a 14,000-sqft facility with 14 acres of test fields in Johnson County, Kansas for plant science research and development of plant nutrition products.
Addressable market. The addressable specialty plant nutrition market for the company, comprised of the U.S., Canada, Mexico, and Brazil, is estimated at $10 billion. This is a highly fragmented market.
- Commodity-type and specialty crops require specialty plant nutrients in varying degrees depending on the crop and soil conditions.
- While used in small prescriptive amounts, specialty plant nutrients play important roles in plant development, and nutrient deficient soils must be replenished to obtain higher crop yields, as ruled by Justus von Liebig’s Law of the Minimum.
The company sells SOP under the Protassium+ brand and specialty plant nutrients under the Wolf Trax (mainly in North America) and ProAcqua brands (primarily in Brazil) (see here)(Fig. 6).
Fig. 6. The competitive landscape in the plant nutrient market. Source.
Substitutes: SOP vs. MOP. The average worldwide consumption of all potash fertilizers is 82 Mt/y, with muriate of potash (aka, MOP) accounting for 86% of all potash used in fertilizer production and SOP representing approximately 9%.
Though MOP dominates the potash market in quantity, SOP maintains a price premium because it differentiates itself as a source of plant-ready sulfur and being suitable for chloride-sensitive crops.
SOP market share in North America. The high price of SOP relative to rock salt gives it farther geographical reaches. European SOP may cross the ocean to compete in North America under favorable foreign currency exchange and Baltic freight rates.
Compass mainly supplies SOP to the western and southeastern U.S. where the crops and soil conditions favor the use of low-chloride potassium nutrients (see here). Being the only SOP producer with production facilities in North America and as a result of its logistically favorable production site near Ogden, Utah, the company captures over 70% of the North American market (see here) (Fig. 7).
Fig. 7. The agricultural product facility of Compass (left) and market share (right), modified from source.
Plant nutrition market in Brazil. Compass operates nine production facilities in Brazil, including a joint venture, producing approximately 950 products, including around 725 in agriculture productivity and 225 in chemical solutions.
The Brazilian plant nutritional market is extremely fragmented with hundreds of market participants, with most participants narrowly focusing on specific product categories and on delivery mechanisms, geographic regions, and crops. Many competitors are essentially resellers, mixers, and marketers rather than producers. There are also around 15 international competitors present in Brazil, mainly from Europe (Fig. 7).
As a result of the competitive landscape, Compass has different competitors for different market situations. It differentiates itself by a larger market presence, an extensive network of point-of-sales distributors, resellers and cooperatives and, increasingly, direct sales to large farmers. It plans to drive growth by hiring additional sales representatives and penetrate the market beyond the mega-farms to reach mid-sized ones.
Five forces. The company's competitive strength can be characterized using Michael Porter's five forces analysis, in terms of the intensity of competitive rivalry, threats of new entrants and substitutes, and bargaining power of buyers and suppliers (see here) (Fig. 8).
Among its three business segments, I believe Compass commands the most durable competitive advantage in the salt business, followed by the North American plant nutrition segment, with the Brazilian segment being the least moated.
- Labor as a supplier to the company is one of the weak links in its chain. In February 2018, workers at Goderich had a 78-day strike, extracting a three-year deal with guaranteed 2.5%, 2.5%, and 3% wage increase in 2018, 2019, and 2020, respectively. Approximately 50% of its workforce of 1,793 in the U.S., Canada, and the U.K. is represented by collective bargaining agreements; trade union membership is mandatory in Brazil, where it hires 1,278 people. Of the 13 collective bargaining agreements in effect on January 1, 2019, five will expire in 2019, four in 2020, three in 2021, and one in 2027.
Occam's razor or second-order thinking. The spread between return on invested capital (or ROIC) and weighted average cost of capital (or WACC) is generally thought to indicate whether a business possesses a competitive advantage or if a business is protected by an economic moat (e.g., here).
The last decade of history of ROIC vs. WACC for the company is illustrated in Fig. 9. The prima facie interpretation would be the wide moat that used to be, prior to 2016, appears to have disappeared.
- There is an element of truth to that simplistic opinion because it is true that the Brazilian segment acquired in 2016, which now accounts for a quarter of the consolidated top line, does not have much a moat to speak of, as has been discussed above, thus diluting the competitive advantage that company once had.
Fig. 9. The evolution of ROIC vs. WACC for Compass Minerals, with the historical risk-free rate of return and implied equity risk premium from here. A sensitivity analysis suggests the higher than usual WACC in 2018 is mostly a result of the increase in beta during that year. Source: Laurentian Research.
However, that superficial explanation appears to have failed to take into consideration certain unusual characteristics of the company.
- Firstly, a natural resources company, once in a while, has to invest a large sum of capital in a long-lead-time project to modernize its facilities or compensate for depleting resource, which typically ruins its balance sheet and disrupts its operations; only after a period of time will efficiency gain become apparent and ROIC recover. In the case of Compass, it started a major investment campaign in 2014 to overhaul the machinery at Goderich, expand the facility at Ogden, and acquire Produquímica in Brazil. These capital-intensive projects have indeed led to heavy indebtedness and caused various operational issues. The management, however, stated that it would bring down the debt leverage now that the Produquímica integration is complete, margins are improving and free cash flow is increasing.
- Secondly, the adverse effect of the three consecutive mild winters between 2015 and 2017 have depressed the ROIC considerably (Fig. 1). Previously, the dry winter in 2012 resulted in some 4-8% decrease in ROIC as compared with adjacent years (Fig. 9).
- The previous management, coming from a fertilizer industry background, may actually have had a steep learning curve to climb in the seemingly stodgy salt business. It perhaps should have taken a more measured pace in launching the five-year investment plan, rather than launching all capital projects in an all-out fashion as it had happened.
New CEO. On April 23, 2019, Compass appointed Kevin S. Crutchfield as the company's next president and CEO, effective May 7, 2019. Crutchfield comes from a coal mining background, recently at Contura Energy, Inc. (CTRA) and Alpha Natural Resources, Inc. (OTCPK:ANRZQ) (see here). The board of directors values his experience in continuous mining and logistics, reflecting its emphasis on the salt business.
2019 outlook. The management raised the 2019 guidance for salt volume from 10.0-10.5 Mt to 10.5-11.0 Mt. Snow events in 1Q2019, which started strong at 112, imply tighter market and better pricing in the following bid season, as is typically the case (Table 1). The management expects a decrease in cash cost in deicing salt production is largely offset by a rise of higher-cost consumer and industrial salt in the product mix.
On the other hand, the company has a lot of work to do in the plant nutrition segments for the rest of the year to make up for a weak start due to unfavorable weather conditions.
The company anticipates annual EBITDA to fall between $310 million and $350 million. With CapEx significantly lower than in 2015-2017, it anticipates the 2019 full-year free cash flow to be $90-100 million, excluding $55 million tax refund expected from the IRS. The management views the quarterly $0.72 dividends as "manageable"; it expects to exit 2019 with reduced adjusted net debt leverage ratio (see here) (Fig. 10).
Fig. 10. The trend of CapEx, free cash flow, and adjusted net debt leverage ratio of Compass. Source.
Longer term. Looking ahead, I believe the salt segment will continue to be strong in cash generation while the plant nutrition business to be an area of growth.
Snow events are impossible to forecast in the short term but in the long run, 1% per year deicing salt demand growth and 3-4% price appreciation should create 4-5% per-year growth in deicing salt sales, more than offsetting labor cost appreciation. It remains to be seen whether the company can successfully expand into adjacent markets (Fig. 4). Furthermore, the management expects EBITDA margins to improve from the current 23% to mid-30s in percentage by late 2020, as Goderich continues to improve to make imported salt unnecessary.
On the back of its advantaged position in SOP in North America and the growth momentum in Brazil (Fig. 11), the plant nutrition segments are projected to post 10% annual top-line growth with an EBITDA margin of around 25%.
Fig. 11. Revenue growth of the Brazilian business segment. Source.
Based on the above discussion, I believe the worst storm has passed for Compass.
- Much to my delight, the sustainable competitive advantage commanded by its deicing salt business appears to have survived a triple whammy of ill-planned capital investments, mismanagement, and a long stretch of mild winters, emerging with its moat in fairly good shape.
- The acquisition of Produquímica may have narrowed the economic moat that the company once enjoyed. However, the thus-diluted competitive advantage is compensated by the growth potential in Brazil. The integration of Produquímica is now completed and the plant nutrition business resumed growth in a fast clip (Fig. 11). The company, in my opinion, still has a lot of headroom to grow in that country, considering the fragmented competitive landscape there.
If 2018 and 1Q2019 are of any indications for what is to come, margins began to expand, profitability is improving, and free cash flow is rising as CapEx decreased.
To the shareholders who hang in there with the stock, yes, the dividends seem to be secure, according to the management and judging from my estimate of 2019 EPS (Fig. 2). Even though a dividend hike may not be forthcoming in the near term, the 5.33% dividend yield is sweet. Such a dividend yield is especially attractive considering it is posted by a recession-resistant, non-cyclical business in an aging bull market.
However, the risk does abound. Weather conditions are hard to forecast. Workers may strike. Foreign exchange gyrations add to the uncertainty. And the company still has a long way to go in further cutting operating cost in its North American plant nutrition business (see here).
If you like the article above, then you may want to check out The Natural Resources Hub where a portfolio of high-alpha investing ideas are covered in various angles, monitored, and discussed by a community of investors...
Sign up today at The Natural Resources Hub for a free trial and benefit from Laurentian Research's in-depth research right away!
Disclosure: I am/we are long CMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.